Central Banking in Times of Crisis*

Introduction

Good morning and thank you for inviting me to participate in this important discussion.

We are in the midst of the worst financial crisis of the past 70 years. Extraordinary disruptions in the flow of credit and liquidity have weighed on the economies in the United States, Central and Eastern Europe, and around the world. As events have unfolded over the past 20 months, the Federal Reserve, together with the United States Treasury and the Federal Deposit Insurance Corporation (FDIC), has implemented a broad range of policies aimed at mitigating the problems in our financial system and the fallout on the rest of the economy.

I believe that our interventions are helping to address the difficulties we face and to eventually move the United States back to financial stability and economic recovery. And, as you are all well aware, capital flows are international. So, these efforts should also be positive factors for financial markets and economic activity around the world.

Today I will concentrate my remarks on the Fed's responses to the liquidity and credit shocks that have affected the U.S. financial system. I will also discuss the challenges that lie ahead and our continued commitment to confront them. I should note that these are, of course, my own views and not necessarily those of my colleagues in the Federal Reserve System.

Credit and liquidity shocks

Trouble began in 2007, when falling housing prices and rising mortgage defaults produced strains in the market for securitized mortgages. As a result, many financial institutions reported severe losses. Famous names such as Bear Stearns, Wachovia, Washington Mutual, Merrill Lynch, Lehman Brothers, and American International Group (AIG), were on that list. Some of these firms appeared unable to survive on their own and were purchased by other financial institutions. In the case of Bear Stearns, this involved assistance from the Federal Reserve. The Federal Reserve and the Treasury also were able to arrange loans and guarantees to AIG in order to avoid large-scale disruptions in markets that had exposures to credit default swaps written by AIG. In contrast, when Lehman Brothers experienced especially large losses, no sale or loan support could be made at suitable terms. As a result, Lehman went into bankruptcy last September.

Lehman Brothers' bankruptcy intensified market participants' concerns over the potential losses on a range of assets, as well as over the ability of their counterparties to meet contractual obligations. One important sector that was disrupted was the money market industry. Worried over losses, investors in money market funds began making redemptions. To meet these redemptions, some funds had to liquidate assets into an already depressed market, further lowering the prices of these instruments.

The disruptions in the money market industry were the product of two main shocks: a credit shock and a liquidity shock. First, because of deteriorating economic conditions, market participants expected greater losses on commercial paper and other short-term securities. This is what I refer to as a "credit shock." Second, the ease of trading these securities worsened: transaction volumes shrank dramatically, and in some cases it was even difficult to obtain price quotes. This is what I call a "liquidity shock." The two shocks are not independent, as deteriorating liquidity conditions can spillover to produce higher losses among market participants. The interplay between credit and liquidity shocks made it difficult for firms to issue all but the safest and most liquid commercial paper. Only very short-term, often overnight, debt was issued when market conditions were at their worst.

It is easy to see the role that "flight to quality" played in these events. And I would like to underscore that "flight to liquidity" alone was sufficiently severe to disrupt the functioning of some markets that were largely immune from credit shocks. For example, in the United States many student loan payments are guaranteed by the federal government. Despite these guarantees, liquidity disruptions have nearly shut down the auction rate securities markets that student loan providers had used to obtain a good deal of their funding. Subsequently, they have had substantial difficulty in attracting investors to other types of securities backed by student loans. A second example is the market for Treasury Inflation Protected Securities (TIPS). Like other Treasury securities, TIPS benefit from the guarantee of the federal government. Yet, in past months they have traded at a significant discount relative to more liquid (on-the-run) nominal Treasuries.

Monetary policy in exceptional times

The Federal Reserve has responded aggressively to these extraordinary events. Since September 2007, the Federal Open Market Committee (FOMC) has lowered the target for the federal funds rate—our standard overnight interest rate policy lever—bringing it to essentially zero in December of last year. In addition, we have made adjustments to make it more attractive for banks to borrow from the discount window.

However, financial distress, the weak outlook for growth, and the prospects for unusually low inflation call for more policy accommodation. With the funds rate near zero, the Fed has had to work to find new ways to inject monetary accommodation into the economy.

One way to make monetary policy more accommodating is to work to lower the unusual liquidity and risk premia that are raising private and longer-term borrowing costs. In this arena, the Federal Reserve has adopted several innovative policies that are providing liquidity support to a range of institutions and markets.

Some of these policies were aimed at easing the liquidity pressures I spoke about earlier that hit the money market funds and commercial paper markets last fall. Two important ones were the Money Market Investor Funding Facility (or MMIF) and the Commercial Paper Funding Facility (CPFF).

Most recently, a new joint program with the Treasury, called the Term Asset-Backed Securities Loan Facility, or TALF, became effective on March 19. The first lending through this temporary facility is designed to make credit available to consumers and small businesses on more favorable terms by facilitating the issuance of new asset-backed securities (ABS) and improving the market conditions for ABS more generally. The TALF is providing financing to investors to support their purchases of certain highly-rated ABS backed by newly and recently originated auto loans, credit card loans, student loans, and small business loans guaranteed by the Small Business Administration. Purchasers of these ABS will be able to borrow from the TALF, using the securities themselves as collateral.

The ABS market has typically played a critical role in providing credit to U.S. consumers and small businesses. However, this market has virtually closed since the worsening of the financial crisis last October. The TALF is aimed at re-opening this market by helping lenders finance new issues. Moreover, the program provides a lending backstop that will enhance the liquidity value of TALF-eligible securities. Since the announcement of the TALF, liquidity conditions in these securities have already improved. It is important to note that the TALF loans are for three years—medium-term loans that are noticeably longer than those available through other Fed lending facilities. So, TALF can impact longer-run interest rates.

Another important feature of the TALF is that the terms on these loans are attractive during current market conditions but are more costly than those that prevail during more normal times. So, TALF loans will become unattractive when conditions improve in markets for traditional sources of funding. Appropriate haircuts on the collateral and funding from the Treasury provide the Fed with credit protection on the facility.

I should also note that, as conditions warrant, we will be expanding existing programs. For instance, the Fed already is undertaking a substantial expansion of the TALF. Last Thursday we added four new categories to the list of TALF-eligible ABS. And yesterday an expansion of the TALF to legacy assets was announced, with the new assets expected to include non-agency residential and commercial mortgaged-backed securities.

Moreover, on March 18 the FOMC decided to further increase the size of the Federal Reserve's balance sheet by purchasing up to $1.15 trillion of additional securities, comprising (up to) $300 billion of longer-term Treasuries, (up to) $750 billion more of agency mortgage-backed securities, and (up to) $100 billion more of agency debt. Prices of Treasuries jumped sharply after the FOMC announcement, with the ten-year yield falling nearly 50 basis points over the day.

Together with the Treasury and the FDIC, the Fed earlier had also taken exceptional measures to attenuate the effect of the credit shock. For example, we provided assistance to JPMorgan Chase in the acquisition of Bear Stearns, and we arranged the ring-fencing of some non-performing assets held by Citi and Bank of America. Moreover, we provided capital to support the purchase of some collateralized debt obligations and the unwinding of AIG's credit default swap positions.

Additional interventions to deal with the credit crisis are being implemented. For instance, there is the Treasury's Financial Stability Plan. The plan includes a Capital Assistance Program to strengthen U.S. financial institutions so that they have sufficient lending capacity to better support economic recovery. The plan also includes a Public-Private Investment Program, aimed at providing greater means for financial institutions to cleanse their balance sheets of what are often referred to as "legacy" assets. Many of the details of this program were released yesterday, including the expansion of the Fed's TALF to legacy assets that I just mentioned.

When economic activity recovers and financial conditions normalize, the use of nontraditional policy tools and the size of the Fed's balance sheet will be reduced, and the FOMC will return to its traditional focus on the federal funds rate. Some of this wind-down process will occur naturally as market conditions improve, given the particular pricing and maturity design features of these programs. Still, financial market participants need to be prepared for the eventual dismantling of the facilities that have been put in place during the financial turmoil. Fortunately, it is most likely that this dismantling would be associated with better economic and financial performance.

Conceptual motivations for these new initiatives

Let me briefly step back and discuss these programs at a more conceptual level. In a well-functioning financial system, arbitrage moves funds across markets and balances out profit opportunities. It thus aligns term and risk-adjusted returns across markets. This is the reason, for example, why our typical moves to lower the short-term risk-free federal funds rate affect borrowing rates over a large range of maturity and risk structures. When financial markets are functioning well, the Fed can focus on the size of the liquidity injection instead of the particular segment of the market in which the injection occurs.

But that is not the case today. There is abundant evidence that arbitrage opportunities remain unexploited. Because of balance-sheet capacity limitations, or because of higher-than-normal uncertainty and risk aversion, market participants are largely avoiding markets that are undergoing unusual stress. For instance, as I mentioned previously, liquidity disruptions have made it difficult to attract investors to several types of securities backed by student loans, even in the presence of a federal government guarantee.

One way of thinking about these developments is that markets have become highly segmented. We do not see funds flowing in to take advantage of apparent profit opportunities with respect to distressed assets. If they were, they could ease liquidity pressures in these sectors and help keep some problems from spilling over into solvency concerns.

The flip side of this market segmentation is that liquidity injections aimed directly at a particular distressed market are less likely to leak out to other areas. The injections thus can significantly improve that market's functioning, seeding its transition to more normal liquidity and risk valuations. This is the rationale for focusing our nontraditional policies on loans and securities that affect transactions in particular key markets where we see points of stress. But a downside is that markets that are not the particular focus of policy intervention could experience some relative disadvantage because of the segmentation.

As stressed markets improve, more normal functioning of the financial system as a whole can be achieved. Market participants will become more willing to carry on their usual arbitrage activities, and segmentation will diminish. This will diminish both the need and usage of the special programs we have created.

Because segmentation will change dynamically, the effectiveness and unintended consequences of credit policies can shift over time and in unexpected ways. This highlights the need for careful design and continuous monitoring of these programs.

The programs I discussed today will help improve credit and liquidity conditions in U.S. financial markets. Since capital flows are international, these initiatives have the potential to positively impact capital markets around the world as well.

The Federal Reserve has also worked together with other countries to address pressures in global money markets directly. For instance, the Fed has established temporary reciprocal currency arrangements (swap lines) with several nations' central banks. These facilities are designed to help improve liquidity conditions in global financial markets and to make it easier to obtain U.S. dollar funding.

Other international efforts are in place to provide direct support to countries that have been particularly affected by the financial crisis. For instance, the International Monetary Fund (IMF) has provided funds to several Central and Eastern European countries, including Latvia, Hungary, Ukraine, and Belarus; and Romania is in talks with the IMF. Moreover, the European Bank for Reconstruction and Development (EBRD), the European Investment Bank (EIB) Group, and the World Bank Group recently pledged to provide up to €24.5 billion to support the banking sectors in Central and Eastern Europe and to fund lending to businesses hit by the global economic crisis.

Conclusions

Modern economic theories usually imply that there is little the public sector can do to offset a cyclical contraction in technology except to offset, to some degree, rigidities that affect the economy's response to the shock. This logic would carry over to financial shocks as well, if we chose to model them as a negative cost shock to an intermediate input.

However, there are reasons to believe that policy has a very different role to play in mitigating the impact of financial shocks. For one thing, the Fed and other financial regulators are themselves part of the financial intermediation process. This means there could be alternative policy instruments that might directly affect the way the economy responds to a financial shock.

Since August 2007, the FOMC's policy decisions have been calibrated to deal with the "adverse feedback loop" between disruptions to financial market stability and the real economy. This focus has influenced not only the setting of the funds rate, but also the implementation of several new policies aimed directly at the financial shocks, some of which I have discussed today.

I believe these initiatives will help in restoring the normal functioning of the financial system. They will also have a stabilizing effect on markets around the world and will therefore eventually help stimulate worldwide economic recovery.

*The views presented here are my own, and not necessarily those of the Federal Open Market Committee or the Federal Reserve System.